An OPEC Deal Extension Isn’t As Simple As It Sounds

It’s been six months now that oil prices have been reacting to OPEC, first to the possibility of an agreement, and then to the production cut deal itself, forged by OPEC to rebalance the market. The deal–initially aired as ‘an agreement to agree on a deal’ in September and signed at the end of November—will likely impact the market for at least the next six months.

Oil prices react to OPEC deal

The agreement clearly states that it is production that OPEC producers are vowing to cut, but Iraqi oil minister Jabbar al-Luaibi has recently claimed—rather emphatically—that it is exports, not production, that serve as the baseline for the cuts. And according to Iraq, the agreed-upon cuts have been all about exports all along.

Of course, exports are the logical ‘by-product’ of production of oil exporting nations, but each of those producers feels the weight of production cuts differently. Each OPEC nation has a specific domestic demand for oil based on population numbers and the share of oil and petroleum products in the energy mix and electricity generation. Each member has unique buyers of their crude, along with differing agendas in keeping and/or growing market shares in various corners of the world.

To cut exports rather than production would hit hard the bottom lines of those who are heavy exporters, so it’s quite clear why an oil cartel whose self-proclaimed mission is to secure “a steady income to producers” chose to cut “production” instead of “exports” in its latest supply-cut agreement.

OPEC producers—especially Saudi Arabia, which shoulders the biggest share of cuts-are desperately trying to maintain their most important market shares such as those in Asia, while measuring exports bound for other destinations in its attempt to comply with the production cuts.

The cartel would have never used the language ‘exports’ in a deal to cut supply, because cutting their exports would mean they would hold a smaller market share. Having a smaller footprint globally would, in turn, mean that OPEC would wield less influence over the price of oil. It’s doubtful OPEC would ever agree to such an unappealing scenario.

But Iraq is uniquely positioned. First, Iraq must contend with the Kurds, as well as international companies, with which it has production agreements that come with penalties for breeching. For this reason, Iraq does not have as much control over production as, say, Saudi Arabia, who deals only with state-run oil. So using export figures rather than production figures may show that Iraq is complying at a higher rate, even though exports are not entirely under their control either. The mere perception of compliance, regardless of the validity, is important as far as the market is concerned.

Another reason why Iraq may prefer to cite exports is because exports are a bit trickier to nail down. There is always conflicting loading data and shipping schedules to contend with, and it’s hard to pinpoint precisely how much oil each OPEC nation has heading out the door.

Production, on the other hand, has concise figures (two figures each, we might add) published in OPEC’s Monthly Oil Market Report—one direct reported figure and one secondary source figure. Exports are even less transparent, especially for Iraq, who has export figures for both the north and the south.

Data compiled by Bloomberg showed that Iraq’s February exports of 3.85 million barrels per day were, in fact, 39,000 barrels per day higher than January levels, which doesn’t seem so compliant.

In October 2016, Iraq’s oil exports were estimated to be 3.89 million barrels per day. So even if the “reference basket” that OPEC used to craft the deal was based on exports, it doesn’t look like Iraq’s compliance is particularly noteworthy—it’s just more difficult to pin down exactly how noncompliant Iraq is.

So, for OPEC, it’s about production cuts, but beyond the wording of the agreement, it’s the message – we are the ones finally doing something to bring the huge oversupply back to balance. The fine print, of course, is – we wanted the price of oil higher and stable, so that we could plug the gaps in our oil-revenue-dependent budgets.

The market bought the ‘balance’ message, and oil prices steadied at above $50 for three months. The initial surprisingly high compliance at more than 90 percent, due to Saudi Arabia going the extra mile, instilled further confidence that OPEC was following through its promised cuts. Almost every cartel producer is boasting near full or overcompliance, and those who don’t comply, notably Iraq, are claiming the deal’s baseline is about exports.

The price gains from the OPEC deal have been capped by resurging U.S. shale output at the higher oil prices. But the recent drop in the price of oil wiped out almost all the price increase that the cartel’s deal has managed to achieve.

The message to OPEC was that it may have underestimated U.S. shale resilience once again, and the cartel’s previous plans for higher prices may prove ill-conceived.

OPEC’s playbook currently is 1) urging full compliance from all signatories to the deal, 2) using Saudis to signal they may be fed up with doing the extra heavy lifting for rogue members, and 3) talking prices up from time to time with messages that the supply-cut deal may need to be extended.

Last week, Saudi Energy Minister Khalid Al-Falih told Bloomberg Television that OPEC would extend the deal beyond June if stockpiles were “still above the five-year average.”

According to OPEC’s own estimates from earlier this month, OECD commercial oil stocks in January were 278 million barrels above the five-year average.

OPEC’s deal now is trying to send a unified message that the members are making every effort to rebalance the market, so it’s unlikely that OPEC will correct Iraq’s insistence that the deal was forged over export figures rather than production figures.

The cartel is a diverse group of nations with various bilateral, trilateral and bloc relations among them. OPEC members rarely act in full concert, and seldom keep production-cut pledges. Their game now is playing the market with the possible extension of the cuts beyond June, and they have time until May to try to talk prices up.

If the cartel doesn’t extend the deal, the glut may not clear soon, further depressing oil prices and straining the already stretched OPEC producers’ budgets. If they decide to extend the deal, they risk losing market share and part of their power to sway oil markets and prices.